The 5 scariest things about ETFs for investors

Everett CollectionDid Janet Leigh just spot ETFs in her portfolio? A scene from the movie “Psycho.”

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Liquidity worries have bubbled up lately in the world of exchange-traded funds, meaning heebie-jeebies about the tradability of certain ETFs.

So here’s a look at that oft-mentioned worry, as well as four other fears.

Sure, ETFs can be low-cost, diversified investing vehicles that track broad market indexes. But you’re no psycho to worry about their relatively quick rise to become a $3 trillion force in global financial markets—or if you fret about the more esoteric funds.

The liquidity worry: “We haven’t yet seen a situation where bond ETFs were confronted with massive sell orders all at once,” wrote Ritholtz Wealth Management CEO Josh Brown on his Reformed Broker blog in late March, adding that “assets in bond ETFs were tiny during the last financial crisis.” Brown highlighted a widely read note from Oaktree Capital’s Howard Marks, who asked “Will ETFs prove liquid in the next crisis?”

A Financial Times column in March said some ETF providers are courting trouble by moving into illiquid securities and taking a large share of the market in areas like developing world corporate debt. “Liquidity mismatches are the classic fuel for financial crises,” the FT said.

Response: “Worst case, [an ETF] will either operate like our standard high-yield mutual fund, or it will end up a like a high-yield closed-end fund,” said Mark Wiedman, global head of BlackRock’s
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iShares business, the world’s biggest ETFs provider, when asked about liquidity worries. “Either case, I just don’t see any evidence of systemic concern.

“If anything, the fact that it trades like a stock instead of just like a fund—[allowing] for buyers and sellers to meet without going through investment banks—we think…actually reduces risk in the financial system,” he said. “Because as we learned, the centerpiece of risk in the financial system is leveraged financial institutions intermediating trading.”

“My counter to those concerns is the problem isn’t the ETF as a structure,” said Dave Nadig, director of ETFs at FactSet. “It’s that the ETF is shedding a light on a broken market structure in the fixed-income market, and ultimately that’s the thing that somehow needs to get fixed.” Barron’s has emphasized that investors in certain bond ETFs must realize they’re “right at the tip of the spear,” as those funds often become the only liquid instrument in a selloff.

ETF.com, FactSet, BloombergSome investors don’t like that stocks increasingly move in step with one another.

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Rising correlations: Stocks seem to increasingly move together, as the chart shows. Market watchers have blamed this on the rising popularity of funds that track baskets of stocks—meaning ETFs and their cousins, index mutual funds. A Financial Analysts Journal paper in 2012 complained about “higher systematic, common trading across a basket of many stocks simultaneously, which means increased overall market risk via higher pairwise stock price correlations.”

Just get over it? “The more money that’s buying and selling blocks of 500 stocks at a time, the more those 500 stocks are going to look like each other. I think that’s just the new reality,” said FactSet’s Nadig, referring to huge trading interest in the SPDR S&P 500 ETF
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and similar funds. It’s a concern if you’re trying pick individual stocks and are “wondering why you’re not being rewarded for your supposed insight into this stock versus that stock,” Nadig added, in a tone implying that’s a fool’s errand. He said more people see investing as an exercise in asset allocation—picking the right mix of stocks and other asset classes, rather than selecting the right individual securities. And even so, Apple
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and Twitter
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for example, have “performed pretty darn differently” in recent days, Nadig said.

FactSetVolatility has fallen since the financial crisis, but what will the future bring?

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The volatility fear: Some analysts fret that markets have grown choppier because of ETFs and other index-tracking funds. For example, a Morningstar researcher in April delved into whether the popularity of Vanguard-style investments—meaning mutual funds and ETFs tied to conventional benchmarks—has led to increased volatility and marketplace fragility.

Not buying it? “There’s actually no evidence to support the claims,” Wiedman from iShares told MarketWatch. “The period in which ETFs have actually risen to some prominence in the financial markets has also been the period in which market volatility has been at historical lows.” He added: “Some might say it’s been suppressed by central bank activity—totally reasonable claim. I don’t say it’s impossible that ETFs could create volatility. I just say that people are making it up, when they claim that they do.”

FactSet’s Nadig said markets have become more volatile over the last several decades because of high-speed trading and changes in how we handle time and information. ETFs aren’t a big factor, according to Nadig. “You could get rid of the ETF structure tomorrow and you would have zero effect on volatility,” he said.

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The proliferation fear: As the sheer number of U.S.-listed exchange-traded products grows toward 1,700 and beyond, some analysts worry that many investors will feel overwhelmed or baffled. “There’s a risk—when the menu expands and expands and expands—just for confusion,” said Ben Johnson, Morningstar’s director of manager research for passive strategies, at a conference in September.

Let it go: Fans of ETFs often say the market will decide when there are too many choices. Skeptics of the ETF industry were saying “Aren’t there enough products?” nearly a decade ago, said Christian Magoon, CEO of ETF sponsor YieldShares, in an interview earlier this year. He also noted the number of U.S. ETFs still stands well below the number of mutual funds, suggesting investors ought to expect more product launches.

Shutterstock.comOver your head?

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Unsuitably complex ETFs: ETFs have made it possible to bet on almost any asset class, said FactSet’s Nadig. However, every investor “isn’t necessarily ready to figure out whether a CDS-based ETF is correctly priced at 2 o’clock in the afternoon on a Tuesday, and isn’t necessarily ready to evaluate the contango in volatility futures, yet those products are available to my mom,” Nadig said.

Gating, keeping it simple: Gating, or keeping some investors from buying more esoteric ETFs, is worth considering, according to Nadig, who notes he’s argued for that in the past. “This conversation around suitability for classes of ETFs is a legitimate one, and one that I know regulators continue to look at,” he said.

Meanwhile, mom-and-pop investors should consider sticking to the biggest, most well-known ETFs tied to familiar indexes, Charles Rotblut, vice president at the American Association of Individual Investors, said last year. Morningstar’s Johnson has said it’s encouraging that data show most investors are, in fact, focused on the big ETFs that are “uber-cheap, uber-liquid and offer broad-based exposures.”

Shutterstock.comOver your head?

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Unsuitably complex ETFs: ETFs have made it possible to bet on almost any asset class, said FactSet’s Nadig. However, every investor “isn’t necessarily ready to figure out whether a CDS-based ETF is correctly priced at 2 o’clock in the afternoon on a Tuesday, and isn’t necessarily ready to evaluate the contango in volatility futures, yet those products are available to my mom,” Nadig said.

Gating, keeping it simple: Gating, or keeping some investors from buying more esoteric ETFs, is worth considering, according to Nadig, who notes he’s argued for that in the past. “This conversation around suitability for classes of ETFs is a legitimate one, and one that I know regulators continue to look at,” he said.

Meanwhile, mom-and-pop investors should consider sticking to the biggest, most well-known ETFs tied to familiar indexes, Charles Rotblut, vice president at the American Association of Individual Investors, said last year. Morningstar’s Johnson has said it’s encouraging that data show most investors are, in fact, focused on the big ETFs that are “uber-cheap, uber-liquid and offer broad-based exposures.”

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